The proceeds from my insurance coverage were more than the adjusted basis of the property I lost but less than the fair market value. Does that mean I can't take a tax deduction?
Yes. Although the fair market value of the property may have been more than your adjusted basis, you don't have a loss for tax purposes. In fact, you have a gain and need to consider the tax treatment of that gain.
What rules apply to gain resulting from insurance proceeds due to loss of my main home and/or contents as a result of a disaster?
There are several special rules, which apply to renters as well as homeowners.
First, no gain is recognized on any insurance proceeds received for unscheduled personal property that is covered in your primary insurance, but is not specifically itemized or valued. These items do not warrant specific insurance and are usually associated with the original policy. An example of “scheduled personal property” not included in “unscheduled personal property” is valuable jewelry.
Second, any other insurance proceeds received for your main home or scheduled personal property are treated as received for a single item of property. You can postpone recognizing that gain for tax purposes by purchasing replacement property that it similar or related in service or use to the home or its contents and that has a cost equal to or greater than the insurance proceeds you received.
Third, if the insurance proceeds exceed the cost of replacement property, you have to recognize gain only to the extent of that excess.
I have a gain from insurance proceeds I received from the destruction of my main home. How long do I have to purchase replacement property in order to postpone recognizing any gain?
To postpone the gain, you must purchase replacement property (another home and/or its contents) within four years after the end of the year in which you realized the gain. You must reduce your basis in the replacement property by the amount of any postponed gain. You will be treated as having owned and used the replacement property as your main home for the entire period you owned the destroyed property. This will be important in determining the tax treatment when you dispose of the replacement property. Also note that some or all of the gain may be excludable, meaning no federal income tax will ever be levied upon it and it does not need to be postponed. See question and answer 7 below.
For example, if your main home had an adjusted basis of $100,000 and you received $150,000 in insurance proceeds when it was destroyed, you have a tax gain of $50,000. You may postpone all of this gain by purchasing a replacement home (including contents) that costs at least $150,000 within four years. Your basis in the replacement home would be its cost less $50,000, the amount of the postponed gain. If your replacement home does not cost as much as the insurance proceeds, your tax gain will be limited to the excess of the insurance proceeds over the cost of the replacement property.
To postpone the gain, do I have to use the insurance proceeds to purchase the new property or can I take out a mortgage?
As long as the cost of the replacement property exceeds the insurance proceeds, you can use funds from any source, including a mortgage, to purchase the replacement property.
How do I elect to postpone the gain?
To elect to postpone the gain, you must attach a statement to your tax return for the year in which you have the gain. The statement must include the date and details of the disaster, the amount of insurance or other reimbursement received, the calculation of the gain being postponed, and it must say that you are electing to postpone the gain by purchasing replacement property. Then for each year during the replacement period in which you purchase replacement property, you must attach another statement to your return containing information about the replacement property. Your Tax Attorney can explain the election procedure in more detail.
What happens if I don't actually replace my property within the four-year period?
If you do not replace your property within the required period, you will need to file an amended return for the year in which you received the insurance proceeds from the disaster to report the gain. If you purchase replacement property but it costs less than the amount of insurance proceeds, you will need to file an amended return also for the year you received the insurance proceeds, but the gain will be limited to the excess insurance proceeds.
Instead of the special rule described above, can I just treat the insurance proceeds I received on the loss of my main home as if it had been sold for that amount?
Yes. Under the normal rules that apply to gain from the sale of a main home, you may exclude a maximum of $250,000 ($500,000 if married and filing jointly). If your gain is more than you can exclude under the normal rules, you can postpone reporting the gain by buying replacement property, as described above.
The California wildfires destroyed my vacation home and I received insurance proceeds in excess of my adjusted basis. Can I elect to postpone that gain?
Yes. However, the replacement period ends two years after the end of the year in which the gain is realized. The special four-year replacement period described above applies only to insurance payments received for the loss of your main home.